“It was an hour before the first shark hit him.” Ernest Hemingway, The Old Man and the Sea
Inflationary pressures remain substantially absent around the world, which in concert with burgeoning concerns about the European political backdrop, has seen negative nominal bond yields spread around the world and deeper into various curves. However, with our expectation that price pressures will unevenly return in the developed world, investors are going to have to work hard to find positive real returns in the next few quarters and years.
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Negligible going on negative…
Just when many thought that global government bond yields couldn’t fall any further, the surprise ‘Leave’ vote from the UK electorate sent them tumbling another leg lower. The days seem long gone when government budgets were constrained by bond market vigilantes. According to the Barclays Global Government Bond Index, roughly 40% of the world’s government bond market currently offers investors a negative nominal yield. Investors are effectively paying certain lucky governments to lend them money. More astonishing still is that the measly 1.4% nominal yield offered by 10-year US government paper is actually juicier than around 85% of the government bond market. The yield on 30-year US government paper beats 97% of the rest of the government space. These statistics alone suggest that the bond market is woefully unprepared for the return of any inflation once the market fallout from Brexit subsides. After all, would any rational investor want to invest in a 1.4% yielding 10-year Treasury bond if inflation is expected to surpass that over the coming quarters? For investors who take a more balanced view of the prospects for inflation over the coming quarters and want positive real returns, the questions then become how much credit risk to take and where.
The case for inflation
We have long suspected that underlying inflationary pressures in many parts of the western world are less terminally absent than commonly believed. The plight of the commodity complex has served to muddy the waters; however, coming quarters should afford us a clearer view, with commodity price declines of previous periods starting to drift out of the inflation data. To provide some perspective, Figure 1 represents a very rough guess at the potential effects on US inflation, all else being equal, if oil prices just stay where they are for the rest of the year.
In the US, labour markets continue to heal, with wages starting to pick up visibly (Figures 2 and 3). Already, real wages are growing at pre-crisis trends amidst tightening labour markets and weak inflationary pressures. Nominal wage growth will likely follow suit once transitory commodity effects wash out from the inflation data. This is spurring greater demand for credit, a missing ingredient for much of the crisis era (Figure 4).
The worry for us is that while the world obsesses over the models destroyed by negative interest rates and the prospects for ‘helicopter money’, the central bankers may actually get what they’ve been so desperately trying to generate – some inflation.
The case for growth
As we have noted in the past, recessions tend to be freak statistical outliers rather than frequent events in the long thread of history. The economy is far more likely to grow than not. The burden of proof should rest overwhelmingly with those calling for a recession – something lacking from the still unbalanced debate around markets and economies.
While Brexit may very well dent UK GDP growth in the short term, we do not think this fundamentally alters our expectation that the global economy will continue to grow above stall speed. Traditionally reliable lead indicators of the US business cycle (the main driver of the global economy) are still suggestive of continued growth. Our favourite ‘desert island statistics’ – the ISM manufacturing and non-manufacturing indices – are still above their expansionary thresholds (Figure 5). The yield curve is still far from inverting (Figure 6), and initial unemployment claims remain at historical lows (Figure 7).
This obviously has important investment implications, particularly as it is the US that probably looks closest to generating durable above-target inflation of the major developed economies. As economic uncertainty from Britain’s EU referendum fades over the coming months, we can plausibly see markets re-pricing Fed rate hike expectations once inflationary pressure starts to become more visible. Our base case is still for the dollar to continue having some support in coming quarters, though we should be wary of predictions of a repeat of the 2014/15 surge in the ‘greenback’ as discussed within In Focus (‘Dollar playbooks’, 27 May 2016). This suggests that some caution deservedly remains with regards to emerging markets local currency debt for example. Also, macroeconomic fears regarding financial stability and debt sustainability in many emerging economies may once again return to the forefront.
In this Compass, we go to the asset class experts for more clues on where and how to look within European and US junk credit right now. The article, ‘Oily opportunities in fixed income’ runs through a checklist for investors to think about when trying to access a space where there has certainly been some indiscriminate price action, but the risks remain high. The European high yield article looks at the very different set of risks and opportunities that characterise the much smaller European junk credit space. As mentioned above, we continue to believe that the next US and therefore global economic recession looks a fairly distant prospect. Much of the gloom implicit in markets therefore looks inappropriate. To us, markets are overly pessimistic in regards to earnings prospects for developed companies (‘Not all that it seems’, Compass Q2 2016). Meanwhile, yields in the junk credit space are discounting a higher default rate than seems probable given our outlook for the US economy. As a result, the two areas where we see investors profitably leaning their investment portfolios are developed equities and junk credit. In both areas, selection is important, but particularly in the latter in our view.